Protecting the nest egg

How can you reduce the volatility of a defined benefit pensions scheme? Judith Crate and Duncan Buchanan explain how to make changes to a scheme without breaking the law

Operating a defined benefit pension scheme could be described as similar to wading through dark, sticky treacle. Employers continue to struggle to contain and control the costs associated with this type of scheme – a difficult task in view of various external factors, including, but not limited to statutory funding requirements. The pension protection fund levy, which in April 2006 will be set by the Pension Protection Fund and will be based on a combination of scheme and risk-based factors, is also set to hit the worst funded schemes the hardest. Exposure to investment return adds to the difficulties.

Add to this a changing breed of trustees who, in the light of professional advice and guidance from the Pensions Regulator, are increasingly being encouraged to see themselves as ‘creditors’ of the employer. In some cases, their new powers under the rules of the scheme may have the employer ‘over a barrel’ when it comes to negotiating the rate of employer contributions.

The impact of pension funding deficits can be serious and wide ranging. They can reduce an employer’s balance sheet to nil, affect its creditworthiness and ability to do business, impact on restructuring proposals and other corporate ventures and, in the worst case, result in insolvency.

Faced with these problems, many employers have chosen to close their schemes to new joiners as one way of reducing financial exposure and future uncertainty.

A more complex option and one which, as yet, far fewer employers have undertaken, is to change the benefit structure for existing members. Such changes could take one or more different forms including:

Increasing the rate of member contributions, meaning members share a higher proportion of the overall cost of providing benefits

Reducing future service accrual, meaning benefits provided in respect of service after a particular date are less generous than those previously provided

Reducing contingent benefits (for example, spouse and child benefits), again in respect of service after a particular date

Closing the scheme to future accrual for some/all employees so that benefits are based on service and salary at a particular point in time, with benefits being provided for the future on a new basis.

Any of these options would need to be reviewed and assessed while considering the following frameworks:

Employment rights – both express and implied

Union presence and collective bargaining agreements

Rules of the scheme and position of the trustees

HR considerations

Adverse media comment

Retention and recruitment

TUPE

The existence and extent of employees’ pension-related contractual rights, in particular any right to accrue defined benefits at a particular rate or cost, will be determined by one or more of the following: job descriptions and offer letters, written contracts, statements in staff manuals and pension handbooks, pension announcements and the duty of mutual trust and confidence.

A union presence, recognised or otherwise, could make introducing changes more difficult – unions now have vast experience of responding to employer proposals to change their pension arrangements. If there are any collective bargaining agreements in place, they should be reviewed to determine the extent to which pension benefits are covered and whether flexibility to introduce changes is limited as a consequence.

It is likely that the consent, or at least the ‘buy in’ of the trustees will also be required to make any changes. Even if trustee consent is not expressly required, they may have other negotiating powers under the rules – for example, a unilateral power to increase the rate of employer contributions and, potentially, a power to trigger a formal wind up of the scheme.

Triggering a wind-up would crystallise a statutory liability to meet the funding deficit on the buy-out basis. The cost of this is likely to be so large that it could, potentially, result in the insolvency of the employer.

Employers should be aware that the trustees’ professional advisers may suggest they seek something in return for their co-operation, for example, an additional, one-off, lump sum employer contribution.

In addition, trustees may seek information, including confidential information on the financial health of the employer, to enable them to independently assess whether the proposed changes are financially justified. It may be wise to ask trustees to enter into a confidentiality agreement before any information is released.

Pensions have been a highly political and emotive issue for some time. This is unlikely to change. Employees’ awareness and understanding of the value of defined benefit schemes has, in many cases, been transformed by national publicity. The potential for HR problems and the ability of an employer to manage any consequential industrial relations problems needs to be assessed and factored into the decision-making process. Timing and consultation procedures and mechanisms should also be addressed as part of HR considerations.

Media interest and adverse publicity could also be a concern. Employers may need to be prepared for adverse press coverage and to be labelled a ‘bad employer’. However, provided the changes are carefully implemented, an employer who goes through this process is unlikely to stand out in the current climate.

Employees who transferred to the company on a TUPE transfer and who were previously members of a defined benefit scheme may enjoy a right to early retirement/redundancy benefits, which have automatically transferred under TUPE. This needs careful consideration.Introducing changes to defined benefit schemes for existing members can be a complicated and lengthy process. However, with careful consideration, planning and implementation, the benefits in terms of cost savings and reduced financial exposure can result in significant benefits in terms of cost savings and financial certainty.

Judith Crate is a senior solicitor and Duncan Buchanan is a partner at McGrigors

Implementing changes

Review employment documentation to determine if there are any restrictions on making the proposed changes

Perform an initial cost/benefit analysis of the savings available from the various changes as against the factors above

Present the proposals to the trustees – employers should understand the strength of their negotiating position under the rules of the scheme before doing so and be prepared to provide financial information

Consider a consultation exercise. The existence of a duty to consult will depend on a number of factors, including the terms of any collective bargaining agreement and the existence of a works council. However, consultation has long been regarded a matter of best practice irrespective of the existence of any legal requirement, and a meaningful consultation exercise could be critical in the event of a subsequent legal challenge. In addition, there may be a legal requirement to consult on the changes with effect from April 2006

Amend the rules of the scheme (if necessary) and implement the changes